Why Lottery Winners Go Broke: Prospect Theory At Work

A lucky few become millionaires overnight by winning the lottery. But before you start playing the game, know that rich people have their own set of problems. Many of them have their own share of headaches that I’m sure you wouldn’t want to have.

Most people harbor the dream to hit it big in some way. But a study I read several years ago revealed the fate of sudden millionaires through lottery tickets or unexpected inheritance. And contrary to what we’d expect, the panorama was devastating. Very few people are able to survive the fame, the incessant supplications for help, the recent accumulation of “friends”, the hounding from salesmen and, especially, the advice and recommendations for “good” investments.

Sudden Wealth: Too Much, Too Soon

One case in particular caught my attention, since I knew the man personally. One of eight grandchildren, he lived most of his adult life struggling to make ends meet, although he knew that eventually he would inherit a sizable sum from his grandparents. When the time came to receive his share, he was 39 years old and unemployed. I had the opportunity to visit him a couple of months later at his luxury home where he had stashed 8 very expensive automobiles (maybe he figured he was Jay Leno).

Image from guardian.co.uk

Since we were not close friends, I did not see him again for 2 years, until a casual encounter in a local restaurant. When I asked how he was doing, he confessed that he had lost everything and was looking for a job. Here’s what had happened to him: perhaps you remember a craze in Russian bonds many years ago. He had invested over a million dollars (his liquid assets) in these bonds, believing the broker who claimed that returns would be “fantastic”. The Russian government defaulted, and billions of dollars disappeared in smoke.

Lottery Winners And The Curse of Sudden Wealth

Another case involves “William “Bud” Post, who won $16.2 million in the Pennsylvania lottery in 1988 but now lives on Social Security. He says: “I wish it never happened. It was totally a nightmare.” There are many horror stories out there of riches to rags, even of attempted murder by relatives hoping to get their hands on the pie.

So why do so many lottery winners go broke over such a short amount of time? In truth, there are many factors as to why the suddenly wealthy end up going broke as quickly as they got rich. I’d like to explore one factor in particular that may contribute to their downfall.

Wall Street Casino

In the investment world, a very interesting theory called “Prospect Theory” analyzes the behavior of investors, and uncovers the fact that emotions are more powerful than reason. This theory actually points out why investors love to hold on to their positions, even as they are sliding in price. It’s hard for us to admit we are wrong, so when we think of cutting our losses, it can be pretty tough. Psychological studies have actually shown that we would rather avoid pain (and therefore take more risks to avoid loss) than pursue pleasure (or gains). Ever seen how a gambler functions? Placed in a position of loss, it isn’t unusual to spot a gambler risking more of their money by placing bigger bets to try to make up for losses. Here’s a bit more about this theory:

Individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some economists have concluded that investors typically consider the loss of $1 dollar twice as painful as the pleasure received from a $1 gain. Researchers have also found that people are willing to take more risks to avoid losses than to realize gains. Faced with sure gain, most investors are risk-averse, but faced with sure loss, investors become risk-takers.

So what happens when volatility and losses rule the investment markets? As we have seen with the stock market during the financial crisis of 2008-2009, investors — especially the small ones like you and me — tend to panic when they see their (paper) investments dwindling rapidly. On a whim, they decide to engage in stock market timing and sell at a loss, or hold onto bad stocks because Uncle Rick (or a co-worker) gave them a “winning” tip. Let’s face it: Wall Street is a huge casino that attracts the gambler inside of all us. Who can resist making a lot of money without really working? Well, the smart ones, for example; those who refuse to let their emotions get the better of them: Warren Buffett anyone?

Greed Is Not Good

The Russian scheme peddled by unscrupulous brokers and the record-breaking Madoff Ponzi pyramid for tens of billions ended up attracting very smart and powerful people who let greed dictate their decisions. Once greed takes hold, people may find themselves behaving irrationally. Over time, greed can prove to be the downfall of many fortunes.

So, dear friends, apply your own personal Prospect Theory in these challenging economic times. If you are holding stock in solid companies, keep them; if your investment is too risky, get rid of the shares, even if you lose money in the process. Now that the market seems to have begun some kind of recovery, it’s a good time to take stock (pun intended) of your financial position and to make the right decisions.

And it is a lot more painful adjusting back down to an economy class lifestyle than it is to never have the windfall in the first place.

For those who do receive a windfall, how should the handle it?

Tell nobody (spouse excepted).
Stick it on deposit for 12 months and do not touch it.
Keep your current job and your lifestyle for at least a year until you have made a written. Plan for a sustainable future.
Spend one hour a day reading about people who lost it all.

a3November 17, 2009 at 9:01 pm

A lot depends on how happy or fulfilled you are already. Since I’m already living in the (small) house of my dreams and am committed to my mission in life, I don’t think a lot would change. I agree with keeping it secret–and along with that goes not doing/buying anything flashy. I have known people who were/are very wealthy and that’s how they live, even though the money did not come through a lottery or windfall.

kenyantykoonNovember 18, 2009 at 12:57 am

I think this is what is called wisdom. Very well written (I have even gone through the links, something I never do). Something that i always wonder is why i have never heard of a financially responsible person like us, the frugal bunch who wins the lottery. I seem to think that in the grand scheme of things, lottery winnings would improve a financially responsible person than one who is not. It is like the financial winds fall for a mentally unprepared mind and becomes more of a curse than a blessing. i have even heard of divorces and killings because of sudden wealth.

Frank CurmudgeonNovember 18, 2009 at 6:24 am

Hold on a sec. Your acquaintance had a luxury home and 8 expensive cars and losing a million or two wiped him out? It sounds like maybe he was never really as rich as he thought he was.

I think the saddest aspect of these stories is the fantasy life that people expect from a million dollars. Put even $10M in the bank and you get about $200K a year before taxes. That’s nice, and for most it means no need to work, but it’s not a life of limos and helicopters.

DiasdiemNovember 18, 2009 at 8:13 am

Honestly, I can’t help but wonder if it only really seems like lottery winnings bring misery because the media only ever covers the failure stories. Surely there must be plenty of people who don’t go on massive spending sprees and invest prudently, and live out the rest of their days wealthy and content. But then, that doesn’t make for good news copy.

CassieNovember 18, 2009 at 9:15 am

Too much too fast is definitely right. People who play the lottery expect to get rich quick and stay that way forever. Unfortunately this is never the case (unless you are smart with the money).

John DeFlumeri JrNovember 18, 2009 at 10:45 am

I can handle the fame and the money. But I too, have seen and read those amazing stories of people who flipped out.

Rob BennettNovember 18, 2009 at 12:28 pm

My reaction is that Prospect Theory may explain why millions of investors who have followed a Buy-and-Hold strategy in the past are reluctant to give it up even after it has been discredited (in my view!). Emotionally, they would rather take on a huge risk of losing more than acknowledge having caused their own losses at an earlier time.

This is what investing is all about, in my view. The math stuff that most focus on is not that big a deal. The emotional stuff is a minefield. We have our priorities in this field backwards, in my assessment.

Rob

Live for ImprovementNovember 18, 2009 at 12:44 pm

Like the saying “easy come, easy go” people who come across sudden wealth are usually not the best at managing money, or they’d already be wealthy. They tend to get caught up in the excitement of the windfall, and blow their money on frivolous things. Someone who lives paycheck to paycheck, will continue to live paycheck to paycheck regardless of how big that paycheck is, unless they learn to better manage their money.

CraigNovember 18, 2009 at 1:01 pm

The same reason you see actors and athletes go broke. They don’t know what to do when they have all the money and spend like crazy and never save.

thomasNovember 18, 2009 at 8:44 pm

As I always say, if you can’t manage the little money you have, how can you possibly manage more of it.

Nurseb911November 18, 2009 at 8:47 pm

I think winning the lottery wouldn’t change my life or lifestyle, but it certainly would help me accomplish a lot more in the sense of humanitarian action that I’ve always wanted to do. Sadly money changes people too often, but I could live with a little more comfort if I had a few million in the bank

Kosmo @ The Casual ObserverNovember 18, 2009 at 8:48 pm

I wonder what the fail rate is for creative types who get rich. Authors, for example.

Many of them come from a rags-ish situation (JK Rowling was on public aid) and it’s not as if they necessarily work harder than athletes, since many athletes work at their trade since childhood, putting in thousands of hours of work over the years.

D MillerNovember 18, 2009 at 11:26 pm

Winning the lottery would certainly cause a change in my lifestyle, but I sure wouldn’t blow it all in one go (or multiple successive goes over a short period of time). I’ll just buy a big house and a car and keep the rest in several different banks, let them grow a bit, then live off the interest.

JohanneNovember 19, 2009 at 7:42 am

Too much, too soon. People who become rich overnight don’t know how to manage large sums of money. That’s why they end up burning through their cash like a blow torch through butter. They’re overwhelmed by the amount that they have that they forget that it’s not limitless. Before they know it, it’s all gone.

Michael Harr @ TodayForwardNovember 19, 2009 at 3:38 pm

@SVB – Thank you, thank you, thank you for bringing up prospect theory. It isn’t talked about nearly enough and it’s such an important element to being able to invest successfully. Knowing the dynamic of how we respond to losses – particularly major losses – is extraordinarily important to maintaining a disciplined investment approach. Prospect theory could well be applied to asset allocation on an individual level…more on that another time.

@KenyanTykoon – you have to remember that lottery players tend to be lower in the income/wealth ranks. As a result, they are less likely to be able to manage money effectively. Even those who are relatively well prepared can wind up making a lot of bad decisions and that’s why even if the lump sum works out to be a better mathematical outcome, the behavioral realities will favor taking the payments. There have been a few wealthy folks that have won the lottery and donated their winnings, but overall, lottery winners will fail with their new found wealth more often than not. It’s the way the deck is stacked.

Funny about MoneyNovember 19, 2009 at 7:56 pm

That’s interesting. In the “hang on because you’re wary of taking a loss” department, somewhere I read that women are less likely to dump a losing stock than men are. Can’t imagine why that would be so…maybe Prospect Theory is in the genes!

As for the miserable lottery winners…is it possible that the reason they were broke and playing the lottery in the first place was that they were kinda irresponsible folks?

Goran Web DesignNovember 20, 2009 at 4:26 am

Windfall earnings generally don’t lead to long term financial stability. I do have some good friends who inherited a milklion each, and started a business doing cellular airtime call cards just as the cellular market was taking off here in South Africa, and they are extremely prosperous today, but they are a notable exception from the norm.

On the subject of greed I have been to several “presentations” over the years for multilevel marketing (read pyramid) schemes of various descriptions. The charismatic techniques used there, focusing on peoples greed to get buy in has stuck with me ever since. Greed is indeed a powerful motivator.

basicmoneytipsNovember 20, 2009 at 7:38 pm

There are a lot of stories floating around like this and they are all tragic to a degree – lottery winners, inheritance, etc.

I do not think I really liken stock market gains to this – I would like to think people in the stock market are a little more realistic about their paper fortune. However, after watching the housing circus, I can understand the irrational exuberance that Greenspan spoke of….

FinavigationNovember 23, 2009 at 7:06 pm

I think the underlying reasons why some lottery winners end up losing it all are because they weren’t financially educated when they came acquired the large sum and/or because they weren’t of the right mind frame to be able to handle the amount of money they won.

Someone who makes a fortune on their own knows what they had to do to build that fortune. They learned about wealth-building through experience. While they may lose the fortune they built, they have the knowledge in their arsenal to be able to build it again (hopefully without making the mistakes that caused them to lose it the first time). The Average Joe who wins a lottery does not have that knowledge, so the mistakes they make are often permanent.

Additionally, people who are not where they want to be financially may sometimes be there because they subconsciously sabotage themselves due to not having the proper mindset to achieve financial success. Things like believing that you have control over your life as opposed to letting life “happen” to you, having the courage to overcome your fear of change and take positive steps toward your goals, and having the humility to keep learning and improving yourself where you fall short are important to being able to achieve and sustain financial success.

SpanishNovember 24, 2009 at 9:16 am

they lose because they lack how to manage their winnings…..and it’s true….instant money..instant loses…

SteveNovember 30, 2009 at 12:13 pm

I don’t think we need prospect theory to show why there are more stories about broke vs. stable lottery winners. Between the bad bet most of us know lotteries are, and the simple fact that a person who won the lottery just saved the money isn’t an interesting story, there are just simpler theories.

LeeDecember 17, 2009 at 9:46 pm

Well, we do have the freedom to be greedy. If we’re living in a world where we don’t tell people who they should love, what dreams they should pursue, and all that stuff, who in the world are we to tell people how to spend their money. The government needs to get out of the business of trying to punish greed. We people spend lots of money on things it helps all the people who are employed by the company who makes it. It’s so odd how the government talks about out of control spending by businesses, but then spends like MADMEN themselves. And tells us we shouldn’t buy expensive things but wonders why there’s no jobs. People should be free to live their own lives. I’m not sure when we started thinking that freedom wasn’t a big deal.

Jason HommelDecember 22, 2009 at 6:44 am

That’s the problem with people instantly getting rich because of something they didn’t sweat on. They suddenly feel financially indestructible and would buy/invest on something without really thinking about it. Invest wisely. That advice applies to everyone.

NickyJanuary 31, 2010 at 10:24 am

I’m pretty sure that if i won the lottery i wouldn’t blow it. I’d buy a house and then just leave the rest in my bank; I don’t need anything else. I have the most important thing in my life already, my girl!

AlexMarch 30, 2010 at 1:17 am

A millionaire is first of all a millionaire in his mind, if you don’t change your mindset you will come back to your initial situation.

PaulApril 5, 2010 at 10:52 am

It seems that no matter how level headed people think they are or might be in a certain situation, an instant win of millions can change all sense of normality and send some people on wild spending sprees, which eventually leaves them back where they started before they won.

MikeApril 26, 2010 at 7:54 pm

It’s too much for people to take. You are the same person no matter how much money you have. It’s a life style change. You need to seek advice from lawyers and dealing with money matters. Suze Orman is really good with money. It’s important to think before you act and not to be stupid. THINK BEFORE YOU ACT. People act crazy because you have to a lot of money. If you are just living from pay check to pay check. Then you come into a large lump some of money. You need to think and be smart and seek help because you do not know what to do at all. At least be smart and get help with your money. REMEMBER TO THINK BEFORE YOU ACT. GET HELP.

MASTERROTHSCHILDJuly 21, 2010 at 9:04 am

Money attracts money. That is how Warren Buffett became wealthier.

BlackSeptember 1, 2010 at 2:01 am

First off, i wouldn’t tell ANYONE (it would be hard, but not even my mom cuz she wouldn’t be able to keep quiet either….of course i would buy a DECENT condo and maybe 2 or 3 cars and nice clothes and take trips. The reason why they fail is because they tell people. I’d rather have my relatives thinking I’m a drug lord than a lottery winner. Another reason is that they have no hobbies and they quit their job (of course i would quit my job if i won 50 million dollars but too much time and too much money is a bad thing. Make smart investments, how bout buying a mcdonalds or microsoft stock (something that u know will succeed)?

DavidDecember 15, 2011 at 11:35 pm

I like how you are all talking like you have won. lol But it’s nice to dream. Yes it would change my life — big house, fast cars and women. Why not?